Deadweight Loss

Definition of Deadweight Loss

Deadweight loss is the loss in economic surplus. Something causes a deadweight loss if its cost to society is greater than its benefit. For example, a tax can create a deadweight loss for society, if the total benefits collected by the government are less than the total cost to society.

Causes of Deadweight Losses

The causes of deadweight losses include externalities, such as pollution, and imperfect markets, such as monopolies. Another source of deadweight losses are policies that distort prices, such as import tariffs and (most) taxes.

Example: Deadweight Loss Caused by a Payroll Tax

Consider a business where the market wage rate for workers is $8/hr and the company can afford to hire 5 workers. Then the government imposes a payroll tax of $2/hr per worker. That means that for every worker hired, the firm must pay the government $2 for each hour the person works.

The cost of workers to the firm is now $10/hr, so the quantity of labor demanded falls. The firm will hire fewer people. Also, the market price of labor falls because of the lower demand. So workers will end up making some amount less than $8/hr and the company will end up paying some amount less than $10/hr.

Suppose at the new equilibrium the quantity of workers hired drops to 3 and the wage rate falls to $7/hr; the cost to the firm for a worker is $9/hr, $7/hr for the wage and $2/hr for the payroll tax. The government gets $2/hr per worker x 3 workers =$6/hr in taxes.

The three remaining workers used to receive $8/hr, but now they receive $7/hr. They have lost $1/hr. Effectively, these workers “pay” $1/hr x 3=$3/hr of the tax.
The workers cost the firm $9/hr, including the tax, so the firm pays $1/hr more than before. That means the firm pays $1/hr x 3=$3/hr of the tax.

There is a “deadweight loss” to the economy: two jobs have been lost and the firm has had to reduce its production

Graphical Representation of Deadweight Loss

Remember that in a perfectly competitive market, the total surplus is the area between the supply and demand curves. A deadweight loss changes the quantity consumed, and the size of the loss is represented by the area between the supply and demand curves bounded on the left by the new quantity and on the right by the competitive equilibrium quantity consumed.

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